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Middle Eastern promise

As Iran's relationship with the rest of the world slowly returns to normal, and as Israel's extraodrinary technology sector continues to produce success stories, Theron Mohamed, Ian Smith and Mark Robinson explore what this unique region has to offer investors
November 6, 2015, Ian Smith, & Mark Robinson

Iran's grand city of Isfahan - the jewel of the ancient Persian empire, boasting the breathtaking Naqsh-e Jahan square (literally, 'image of the world') - and, most notably, home to the latest outpost of Debenhams (DEB).

In fact, it is the fifth store that the clothes retailer has opened since it arrived in the country in 2009, operated through franchise partner Lilian Mode. Through a period of extremely strained diplomatic relations, which at one point saw protesters storming and ransacking the British embassy in the capital Tehran, Iranian consumers have been getting their fix of middle-class knitwear.

Life has not been so rosy for lender Standard Chartered (STAN), which is still trying to shake off the repercussions of its operations in the region. In 2012, the bank had to pay out $667m (£441m) for alleged breaches of international sanctions running up to 2007. It has also paid out $300m after problems with its anti-money laundering compliance system.

In September, the Financial Times ran a report about documents suggesting the bank "continued to seek new business from Iranian and Iran-connected companies" after 2007 - activities which could lead to further fines and even the loss of the bank's crucial US dollar clearing licence. It is of little surprise, then, that the bank has hired a head of compliance for the region as it looks to avoid similar potholes.

Which brings us to the present. Iran's accord with six world powers on its nuclear programme, signed in July, was a historic moment. The deal has the potential to open the Middle East's second-largest economy to a trading relationship with the US and Europe that has not existed since the overthrow of the western government-backed dictatorship in the late 1970s.

Although hawkish rhetoric from both countries is a constant signal of the pact's fragility, Iran has already started to decommission nuclear centrifuges to fulfil its side of the deal. Indeed, European companies are actively working towards the lifting of sanctions, which could still happen this year, but is more likely to come in the early part of 2016.

France is keen to build on the strong historical links between the two countries. Its cosmetics company, Sephora, part of the luxury group LVMH (EPA:MC), is planning to open several shops in the country from next year. The luxury brand association Comité Colbert is reportedly planning a trade delegation in the spring.

UK business is keen not to be left behind. We take stock of the impact that lifting sanctions could have on international trade, not to mention the energy market, where the energy industry is already well ahead of the politicians. Our sectors editor Mark Robinson gives his take below.

For the private investor, most of the immediate opportunities for investment in the region lie with Iran's great regional rival Israel. The country's vibrant technology sector has brought us a variety of companies offering digitally savvy products, but it is also known for providing fallen angels such as Plus 500 (PLUS), formerly an Aim success story until it realised that its compliance with money laundering regulations left a little to be desired.

Our technology correspondent Theron Mohamed tells the story of some recent stellar rises, and some impressive falls, among the country's quoted start-ups.

 

Iran: open for business?

Iranian president Hassan Rouhani's Twitter lackey chose the hashtag #ConstructiveEngagement to caption the historic photo opportunity featuring UK prime minister David Cameron and Mr Rouhani at September's United Nations summit.

It is a fair description of the relationship between Iranian business figures and their overseas counterparts as the diplomatic relationship has improved, with the first Europe-Iran Forum taking place late last year.

The second, held over two days in Geneva in September, boasted among its speakers the vice governor of Iran's central bank, Gholamali Kamyab, and Hassan Ghalibaf Asl, chief executive of the Tehran Stock Exchange, as well as European investors and diplomats.

Organiser Esfandyar Batmanghelidj says for European companies the question of setting up business in Iran has gone "from speculation around the size of the opportunity to what does a successful strategy look like?".

Mr Batmanghelidj sees opportunities across energy, automotive, insurance and other sectors once Iran is "plugged in" to the global supply chain following the lifting of sanctions.

Debenhams' experience is just one illustration of the high-street fashion demand among Iran's urban population, and this is seen as a major opportunity for European companies, as the French luxury charge demonstrates.

"Anything that touches the consumer is going to be big," says Mr Batmanghelidj. "The demand for luxury in Iran is very, very high and certainly [the market] will increase as spending returns to pre-sanction levels."

To get an idea of the growth potential, companies can use Dubai as a decent proxy for the appetite of Iran's higher earners. "Anything really that is in Dubai has been exposed to Iranian consumers because they go to Dubai to do a lot of shopping."

 

Historical baggage

The history of British business in Iran is hardly harmonious. A good start date is 1901, when William Knox D'Arcy was granted a concession to explore for oil in all of the country save its five northern provinces. The British eventually struck lucky in the south-west of the country seven years later.

By the late 1940s, the Anglo-Iranian Oil Company (AIOC) had become the target of a rising socialist and nationalist fervour, with growing criticism of the paltry royalties and few jobs offered by the company in return for its oil profits.

The crunch year was 1951, when the nationalists succeeded in nationalising the AIOC, and their leader Mohammad Mosaddeqh was appointed prime minister. The backlash in the British and US led to the overthrow of Mosaddeqh in 1953, in a coup d'état historians agree was orchestrated by the western powers' intelligence agencies.

This intervention left a deep scar on the national consciousness, and the popular uprising that led to the revolution of 1979 can be understood as a rejection of western influence in the country.

Commentators now believe that the picture of the UK is improving among the powers that be in the country. "That historical baggage is being dealt with," says Mr Batmanghelidj, as evidenced by the Iranian authorities "throwing a bone" to the BBC and other British organisations.

 

The energy perspective

To understand what's potentially on offer for western oil interests following July's agreement on sanctions, we first need to appreciate the scale of Iranian reserves and the fall-away in export volumes over the past four years.

Iran matters because of the scale of its energy assets and their low-cost profile. The Islamic Republic remains the third-largest producer within Opec and it boasts the second-largest proven reserves that are readily accessible through conventional drilling techniques.

It also controls the world's second-largest gas reserves - around four times the size of Europe's - yet it accounts for just 1.6 per cent of global output. That, in itself, presents an extraordinary opportunity for companies such as Royal Dutch Shell (RDSB) that can offer the requisite technical expertise in gas liquefaction and transportation.

 

Natural attrition and export volumes

The sanctions have degraded Iran's ability to replace lost production. And the consequent drain on finances has resulted in the cancellation of a number of capital-intensive projects, while domestic drillers have found it harder to meet ongoing operating expenses. The upshot being that Iran will increasingly struggle to replace natural attrition in its fields.

Iranian production peaked at 4.2m barrels of oil per day (bopd) just prior to the global financial crisis, but by midway through 2011 output had drifted back to around 3.7m bopd. That was the point at which US and European sanctions were expanded to target Iran's energy sector. Estimates differ on the extent of the subsequent contraction, but daily production in September is thought to be at least 500,000 barrels down on the 2011 rate, and perhaps as much as 1.2m barrels.

The fall-away in export volumes is even more pronounced. Iranian oil exports declined to an average of 1.4m bopd through 2014, according to the US Energy Information Administration (IEA). That represents a 46 per cent pullback from the rate prior to the sanctions. Iran had been shipping its crude to 20 or more countries before imposition of the west's trade restrictions, but this has been reduced to just half-a-dozen destinations: China, Taiwan, India, Japan, South Korea and Turkey.

The state-run Islamic Republic News Agency recently stated that within a week it would be possible to crank up daily production by 500,000 barrels once sanctions are curtailed and by 1m barrels a day within the space of a month. Although these claims are somewhat optimistic, there should be no shortage of contracts linked to remedial work once Tehran is given the green light. The country needs up-to-date western expertise if it hopes to increase output from fields that have been partly depleted using outdated - some would say 'inefficient' - drilling methods and equipment.

 

Petrochemical and refining opportunities

Oil services companies and specialist engineers have seen their earnings eroded since crude oil prices went into a tailspin last year, so Iran's looming rehabilitation could provide a welcome source of new business. This was borne out in August, when a trade delegation, including representatives of Amec Foster Wheeler (AMFW) and Scottish industrial engineering company Weir (WEIR), visited Tehran as part of a diplomatic offensive to mark the reopening of the UK embassy.

It's worth noting that even prior to the imposition of sanctions; Iran's energy infrastructure assets had reached a parlous state through decades of under-investment. Nowhere is this more apparent than in Iran's derelict refining and petrochemical sector. Even when exports were flowing unabated, the country was heavily reliant on 'added-value' imports due to a chronic lack of refining capacity. The economy spends billions of dollars on finished oil products every quarter despite having one of the largest global reserves of crude oil. If Tehran was to adopt one strategic priority - short of getting the bomb - it should be the rapid expansion of the country's refining segment. And there is evidence to suggest it's doing just that.

 

The National Iranian Oil Refining & Distribution Company (NIORDC) was holding talks with oil services firms well ahead of the UN resolution on the rescinding of sanctions. Iran has already started pre-construction works on the Siraf refinery complex, which will be the largest in the country. A number of European companies are vying to secure contracts on the $2.8bn project. On completion, Siraf will have a processing capacity of 480,000 bopd. About 60 per cent of the feedstock at the plant will be processed to 270,000 barrels of naphtha per day, which Iran will ship to Asian chemical makers, who will convert it into ammonia for fertilisers and plastics.

 

Marginal benefits and long-haul contracts

Iranian officials have said that Tehran is now ready to offer 50 new projects to international investors. It's estimated that upwards of $100bn in new investments will be required to rebuild the country's creaking energy infrastructure, while Iran's Energy Ministry also plans to scale up production towards 5.7m bopd over the long haul. Big integrated players such as Total SA (TOTF.PA), BP (BP.) and ExxonMobil (US:XOM) have made no secret of their desire to re-enter the Iranian market, but given the scale of the required capital commitments it's likely that they would only consider doing so on a long-term contractual basis. That's at odds with the bulk of deals that have been brokered with state-run energy enterprises in recent years, but we think that Tehran realises it still needs western capital and expertise to drive the industry forward.

Despite the political risks, western oil companies would be keen to increase influence in the region. Consider the marginal benefits linked to Iran's low-cost profile: the cost of crude oil production in Iran averages around $12 per barrel; and the break-even cost for developing a new oilfield is in the $25-$30 a barrel range - only a few of the Gulf States can match that rate. And there are obvious advantages from a strategic perspective, but also in terms of logistics. Around a third of all seaborne traded crude and almost a fifth of all the oil produced globally is transported through Iran's Strait of Hormuz. Iran threatened to shut off the Strait of Hormuz in 2011 in response to the US-led sanctions, but this did little to derail markets since there was confidence in the US's ability to resolve the issue (by force, if necessary).

The knock-on effects of low oil prices and the imposition of sanctions have combined to place western energy companies in a position to negotiate along favourable terms. Put simply: Iran's political stability is vulnerable with Brent crude trading in the $50-$60 a barrel range. Around 60 per cent of the economy is centrally planned, while price controls and subsidies, particularly those on food and energy, present a growing fiscal burden to the state. Admittedly, Iran still has substantial foreign currency reserves to utilise as a buffer against low prices, although it hasn't been able to access all of these since the imposition of sanctions.

 

The regional power struggle

Iran boasts a youthful and highly-educated populace, but the nation's investment in human capital has been undermined by insufficient foreign and domestic capital flows and constraints on free enterprise. It's perhaps unsurprising that increasing numbers of young, skilled Iranians have sought foreign employment opportunities, resulting in a significant 'brain drain'.

This threatens to become a structural problem for the Iranian economy if the nation's exports are stymied over the long haul, even given growing export links with India and China. While Iran's rulers fret over undue western cultural influence, they know that by opening up trade it invariably results in a cross-fertilisation of ideas. In the long run, if theocracy were to lose its grip, it would be ironic if trade ultimately trumped ideology, just as it did in post-Maoist China.

The prospect of renewed opportunities for western companies needs to be set against Saudi Arabia's determination to undermine Iran's political ascendancy in the region. Even if sanctions are relaxed or removed altogether, the price of a barrel of crude remains the central issue. Any rise in production from Iran will extend the glut in crude oil markets, and the country has around 40m barrels in residual inventory. Unfortunately, the regional power struggle in the Middle East makes it unlikely that Opec will reduce its current quotas. Iran and a number of fellow Opec members want Brent crude trading at or above $70 a barrel. But Saudi Arabia, as the de facto leader of the cartel, wants to keep the screws on Shia Iran for as long as possible.

 

Investing in Israel

Sometimes referred to as the second Silicon Valley, Israel has the largest technology sector per capita in the world. Together with life sciences, technology accounts for more than half of the Middle Eastern nation's exports. More than 75 Israeli start-ups have bloomed into billion-dollar businesses in the past four decades, and a flurry of floats in recent years has given the country a disproportionate presence on global stock exchanges.

For example, Mobileye (US:MBLY) became the largest flotation in Israel's history after it secured a valuation of $7.5bn (£4.9bn) on the New York Stock Exchange in 2014. BMW and Honda rely on the group's camera-based technology to alert drivers of potential collisions, while Tesla Motors is using it to develop a self-driving car. Another national success story is CyberArk (CYBR), an enterprise cyber security group with a market capitalisation of $1.7bn.

Rather than going public, most Israeli companies are bought out by multinational companies seeking to tap into the country's talent pool and economic growth. For example, advertising titan WPP's (WPP) Kantar Media invested in Tel Aviv-based data analytics group BIScience in July, while M&C Saatchi (SAA) recently opened an Israeli branch after acquiring a local advertising agency. And this summer, online bingo operator Stride Gaming (STR) agreed to acquire Israeli mobile app developer InfiApps, whose biggest hit is Slot Bonanza - a social casino game with over 500,000 users.

Gaining exposure to Israel can be rewarding, but investors should exercise caution. Shares in Plus500 (PLUS), an online trading services group founded by two Israelis, slid sharply this year after management froze thousands of UK accounts in order to comply with money-laundering regulations. But within months of the fiasco, the group accepted a £460m takeover bid from gaming software group Playtech (PTEC), which counts Israeli business tycoon Teddy Sagi among its largest shareholders. Mr Sagi's other ventures include Crossrider (CROS), a digital advertising technology group that uses 'big data' analysis to help around 220m monthly users maximise their returns on desktop and mobile advertising. He also holds a sizeable stake in international payments group SafeCharge (SCH), which processed more than $3.3bn-worth of transactions in the first half of 2015.

Other Israeli companies include XLMedia (XLM), which listed in April 2014. The mobile marketer, which funnels players to online gambling websites in return for a cut of the operators' winnings, has cashed in on the advertising industry's seismic shift from desktop to mobile campaigns. It has also accelerated growth through international expansion, technology investments and acquisitions such as social media marketer EDM. Meanwhile, Taptica (TAP) - formerly Marimedia - helps advertisers to optimise marketing spend and precisely target campaigns. In June it launched a platform where publishers can sell mobile and video ad slots in real-time auctions, and it recently agreed to acquire fellow Israeli ad-tech group and Facebook partner AreaOne. Similarly, Matomy Media (MTMY) runs digital ad campaigns and counts French media giant Publicis among its shareholders. Adgorithms (ADGO) offers a more speculative option: Albert, its self-learning algorithmic software, maximises returns for brands and agencies and minimises fraud by automating and optimising their advertising campaigns.

Plenty of Israeli businesses operate outside of the capricious online advertising industry. Telit Communications (TCM), a specialist in machine-to-machine (m2m) communication, posted double-digit sales growth for a sixth consecutive year in the first half of 2015. It has also bolstered its presence in the enormous automotive market by acquiring Dutch telematics group ATOP, and continues to profit from surging demand for connected devices. Another alternative is Cineworld (CINE): the cinema chain gained a foothold in Israel following its merger with Cinema City in February 2014, and recently opened a 16-screen cinema in central Jerusalem. Admissions in the nation leapt 14 per cent in the 26 weeks to 2 July, fuelling a 12 per cent rise in divisional box-office takings.

The slew of smaller Israeli companies listed in London includes BATM (BVC), a telecoms and medical solutions company working with Cisco (US:CSCO) and Israel Electric Corporation to establish a fibre carrier capable of competing with Bezeq, the country's incumbent operator. There's also Servision (SEV), which designs and manufactures digital security systems for Gatwick airport, Israeli bus operator Egged and other customers.

The continued success of Israeli companies has given them credibility among international investors, but the downside is that their shares often trade at punchy ratings. One exception is XLMedia, whose shares trade at about 13 times broker Cenkos's forecast earnings for this financial year, and come with a prospective yield of 3.6 per cent. We're also bullish on Telit, SafeCharge and Cineworld, and see considerable value in shares of Matomy.

 

 

Israel's unlikely rise

How has a small, isolated country with few natural resources, surrounded by hostile countries, successfully competed on the global stage? The authors of Start-Up Nation The Story of Israel's Economic Miracle attribute its outperformance to innovation and chutzpah, which have become part of the national identity. Its success may also reflect the large population of brave, pioneering and enterprising immigrants: more than 3m Jews have migrated to Israel since 1948, and droves of Russian, Polish, Hungarian and German Jews fled to their spiritual homeland over the preceding six decades. Moreover, many Israelis have learnt how to lead, work as a team and exploit enemies' weaknesses due to mandatory military service, and the Israeli government has invested heavily in research and development. Meanwhile, writers Malcolm Gladwell and Nicholas Nassim Taleb have proposed that adversity can engender resilience and drive people to outperform.

Perhaps the most compelling theory is laid out in a May 2014 issue of Harvard Business Review. Two Israeli management consultants and a Harvard business professor argue that Israeli companies have punched above their weight by picking their fights carefully. Rather than taking on overseas giants with dominant brands and deep pockets, or local businesses with connections, cultural knowledge and familiarity with regulations, they have targeted 'middle ground' markets that are too small and costly for global companies to bother with, but offer a sizeable opportunity once combined.

Israeli companies also seek out niches where they have superior technology or operational nous to locals, won't face biased regulation and can compete financially. They often partner with or acquire local businesses to enter markets under the radar. The authors give the example of Amdocs in the 1980s: small US software companies lacked the technology to compete with the telephone directory software group, while tech giants IBM and Microsoft were focused on providing a broad suite of software products. Today Amdocs is the global market leader in telecommunications billing automation solutions - it earns over $3bn in annual revenues and operates in more than 70 countries.

When the competition tries to catch up, Israeli businesses lengthen their lead through acquisition and innovation. "Israeli companies have demonstrated that with an entrepreneurial spirit tempered by humility and careful planning, small- and mid-size companies can succeed abroad," the authors write. "By pursuing middle-ground strategies, they can become tomorrow's global giants."